Annuities: The Good, the Bad, and the Ugly!
Annuities have received a lot of publicity, both good and bad, over the last 20 years, and have evolved greatly in recent times. Annuities are essentially an insurance product, offered by insurance companies using an investment engine to potentially offer an income source when you provide a sum of money, either up front or over time in some cases, and are a contract between the insurance company and the purchaser. The insurance you receive is a policy against running out of money in retirement, that is, outliving your investment portfolio or part of it. Let’s look at the different aspects of this:
The Good: Annuities can provide hedges against market volatility and provide guaranteed income.
There are different kinds of annuities, the main types are Multi-Year Guaranteed Annuities (MYGA’s) that provide a guaranteed return for a specific amount of time, Single-Purchase Instant Annuities (SPIA’s) that can provide guaranteed income for a lifetime or specific period of time, Fixed-Index Annuities that track returns on one or more market indexes while providing downside protection, and Variable Annuities that allow one to choose a greater variety of investments within the “investment sleeve” of the annuity, but carry greater market risk.
Many times, the latter two annuities carry income riders which can be purchased to provide guaranteed retirement income, which can then still return contract value to beneficiaries if the annuitant (contract owner) passes away shortly after beginning to take income.
Earnings from Annuities are tax-deferred, so you won’t have to pay a tax bill on them until the contract is surrendered and the annuity is cashed out. Many times, this can have a net positive bottom line on the tax bill. Earnings are often “stepped up” from year to year, meaning they cannot go down in value, and this can often apply to a benefit base that you might draw income off with an applicable income rider. The guarantees against contract value dropping or income for life can make sense for retirees or people nearing retirement that want to lock in some of their portfolio against market volatility.
The Bad: Annuities have a fee structure that can significantly impact returns and can also limit earnings under positive market conditions.
The insurance company will often charge you for the cost of insuring your investment against loss or providing income, and this comes in the form of M&E (Mortality and Expense) fees, administrative fees, Rider fees, and surrender charges if you cancel the contract early. This can really add up and take a big bite out of your investment returns and slowly eat at the value of your contract. The Annuity is also only as good as the financial strength of the company offering it, and these companies can lower the payout rates after a year in some cases, so it is important to read the fine print of a contract before signing it.
While the Annuity can provide downside protection, you are also limited with the upside of returns in a contract like a fixed index annuity that provides a “cap” on your returns. Let’s say the S&P 500 is the market your annuity’s return is linked to, and it returns 20% in a year. The cap may allow you to only earn 7% max for the year, so you gave up 13% returns for the year to insure against loss. When the market is positive 70% of the time, this is not usually a good choice for a younger, long-term investor.
The Ugly: Annuities are still “sold” to people by Advisors to earn commissions and may not be the best choice for an investor.
While many annuities are “suitable” for an investor, they may not be the ideal first choice. Make sure that you are working with an Advisor that you trust that is acting as a fiduciary like a Certified Financial Planner™ or other designation that is bound to put your interests first when purchasing an Annuity. Unfortunately, there are still unscrupulous advisors out there that will try to sell an annuity for a large commission that the investor doesn’t really need, and this gives the industry a bad name.
As Fee-Only Advisors, F5 Financial is committed to helping you navigate the complex world of annuities and help you determine if one is right for you. For more information on how we can assist you please visit us at www.f5fp.com or schedule a free consultation at https://go.oncehub.com/f5fp.
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